China: Falling Dominoes

Last month, I called attention to an article in Caixin magazine about the implosion in Beijing of something called a “credit guarantee company,” and examined the potential risks such entities pose to China’s financial stability.

Today, Caixin published another must-read articleabout a new crisis in which credit guarantees — this time directly between borrowers — have triggered a mini financial meltdown in Hangzhou:

The Zhejiang government is scrambling to settle a credit crisis threatening banks and financial institutions that altogether issued about 6 billion yuan in loans to scores of companies.Sources say 62 companies, from furniture makers to import-export traders, have been affected to varying extents by the collapse late last year of Hangzhou-based property developer Tianyu Construction Co. Ltd.The companies were financially linked to Tianyu through a province-wide, reciprocal loan-guarantee network. Tianyu’s sudden failure raised the specter of a domino effect of defaults taking down every network participant and devastating their lenders.“After Tianyu went bankrupt, banks in Hangzhou started calling in loans to other firms guaranteed by Tianyu,” said the owner of a company tied to the network. “That had a ripple effect and affected a number of other companies.”

The web of interlocking, often incestuous, and sometimes circular credit arrangements is reminiscent of Wall Street in the lead-up to the subprime crisis, in which a relatively small amount of mortgage losses, which most people believed could be contained, triggered a chain reaction that brought down major banks and froze credit across the entire global economy. So how did Hangzhou’s banks allow this situation to develop?

One credit analyst said Zhejiang banks have been blindly trusting loan guarantors while failing to properly examine and screen loan candidates. An official at China Construction Bank’s Zhejiang branch said his bank should have better analyzed potential borrowers’ financial conditions, not just guarantees and promises.

We’ve seen this before with Zhongdan. The banks, in turn, blame borrowers taking what now look like stupid speculative risks (but at the time looked like a sure thing):

“Zhejiang’s business owners were spoiled by easy access to credit, especially in 2008 and 2009,” said a credit manager at one bank. “Back then, they could always get loans using land as collateral and could always make money by investing in property.”

There’s probably enough blame to go around — as there always is when credit flows freely — but one thing is becoming clear:

The reciprocal nature of the guarantee network stripped real bank loan guarantees of any value, argued another banker. The system has made all its participants mutually vulnerable to an economic downturn, he said.Now that property development can no longer guarantee profits, the banker said, borrowers and guarantors are in trouble together.Cash flow at some enterprises has fallen to dangerously low levels, said a bank loan officer, so that they’ve been forced to survive on credit. Many ran out of cash after pouring money into speculative property investments, he said, which flopped after the central government imposed real estate development restrictions in 2010.

In other words, a lot of these firms are actually insolvent and are just borrowing from Peter to pay Paul, in order to postpone the day of reckoning. Of course, the government could step in and bail everyone out. As the article notes, that’s what happened in 2008 in the neighboring city of Shaoxin, when a local petrochemical company that had issued similar loan guarantees ran into trouble.

But before we take too much smug comfort in assurances that the Chinese nanny-state will surely “resolve” (i.e., foot the bill for) everyone’s losses, making them magically go away, here are a couple points worth noting:

Even if everyone in Hangzhou is eventually bailed out, the interim effect on the real economy is chilling. Companies that are hanging by a thread, with almost no access to working capital or investment funds, certainly aren’t going to be contributing to GDP growth. Bailouts, when they do happen, don’t make losses go away, they just impose them on someone else — the drag on growth remains.

The quotes cited above highlight the central role the property market plays in China’s financial system. For the past several years, higher property prices led to more lending, which led to even higher property prices and onwards and upwards. Now that the market has turned, lower property prices are undermining the basis for both past and future lending, and shutting down China’s engine of investment-led growth. (If these words sound familiar, that’s because I warned exactly this on Bloomberg last year, when China’s real estate downturn had just begun).

In my blog post last month, I wrote that I couldn’t really tell the scale and scope of the risks posed by credit guarantee companies like Zhongdan. Just today, I came across some numbers from the China Banking Regulatory Commission (CBRC) — courtesy of the BoA-ML research team in Hong Kong — which say that, at the end of 2011, China had 8,402 credit guarantee companies, which had total assets of RMB 931 billion. Notably, those assets had grown by 57.2% over the previous year. Although the total assets figure adds up to just 1.7% of total loans outstanding in the Chinese banking system, the increase in 2011 equates to around 5% of net new loans issued that year. More importantly, the inter-company guarantees at the heart of the Hangzhou Tianyu meltdown add a whole new dimension to the exposure of Chinese banks, beyond the professional guarantee companies themselves.

Tianyu was one of a handful of relatively small real estate developers that were allowed to go bankrupt recently, presumably because they weren’t seen as worth rescuing. Yet allowing even that small thread to be pulled unraveled a whole web of credit relationships that put numerous banks and businesses in danger. Now think what could happen if a developer like Evergrande (one of China’s ten largest, which last week was accused of hiding the fact that it is actually insolvent via massive accounting fraud) went bust. The domino effect would be orders of magnitude larger, and hard to preemptively anticipate.